ABSTRACT
This study presents an empirical analysis of the impact of statutory minimum share capital and equity requirements, dividend restrictions and thin capitalization rules on companies’ capital structure. The study is based on the information available from the Amadeus database in respect of a sample of companies of the EU countries. The results of the study give support to the hypothesis that companies operating in the conditions of statutory maximum dividend restrictions tend to have a lower demand for debt. The existence of thin capitalisation rules appears to decrease companies’ debt utilization. Requirements concerning minimum share capital and equity levels do not seem to have a significant impact on companies’ capital structure. Further econometric analysis of the above issues with the incorporation of various micro and macro level control variables would be needed to substantiate these preliminary results.
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DOI: 10.3923/ijaef.2009.1.11
URL: https://scialert.net/abstract/?doi=ijaef.2009.1.11
INTRODUCTION
In most countries, a significant volume of legislation has been adopted to regulate financial affairs on a company level for the purpose of promoting companies sustainability and protecting creditor rights. These statutory regulations include minimum share capital and equity requirements, dividend restrictions and thin capitalisation rules. Thin capitalisation rules refer to statutory regulations, which limit the deduction of interest cost from companies income tax base in the situations where the debts of the company are regarded as too high compared to equity. Thin capitalisation rules usually define a maximum debt to equity ratio, whereas companies using external finance beyond this level are not allowed to reduce the income tax base by the interest cost relating to the excessive portion of debt. An important role of thin capitalisation rules is to tackle potential tax avoidance issues.
The common feature of these rules is that they imply on companies capital structure and may in various ways constrain voluntary choices between debt and equity financing, as discussed for example in Hazak (2006a). There are significant differences in the corporate law environment of countries, including within the European Union.
This study seeks to provide a preliminary empirical analysis of the impacts of statutory minimum share capital and equity requirements, dividend restrictions and thin capitalisation rules on companies capital structure. The study constitutes a small part of a larger effort to study from the theoretical and empirical perspective the legal factors that influence companies financing decisions and sustainability. The results of these studies may bring out a suggestion for significant changes in some countries economic policy and legislation.
Several extensive literature analyses have been prepared on the formation of companies capital structure, including Prasad et al. (2001), Myers (2001) and Masulis (1992). These studies cover, besides the impact of legislation, also research results on many other aspects of companies financing decisions.
In general, modern literature on the structure of capital starts from the non-tax model of Modigliani and Miller (1958). One of the key outcomes of this model is that the capital structure does not have any impact on the companys value and the cost of capital. The model assumes a perfect capital market and non-existence of corporate taxes. In addition, other idealisations are made. In a later study, Modigliani and Miller (1963) introduced corporate taxes to the previous model. Their updated model shows that as a result of taxes, debt becomes a more favourable source of financing than equity.
Many subsequent studies take the work of Modigliani and Miller (1963) as a basis, by removing constraining assumptions or taking into account additional parameters. One group of such literature deals with the impact of various adjustments to taxable profit on companies capital structure. DeAngelo and Masulis (1980), for example, incorporate tax depreciation and investment tax credits to the analysis. They conclude that the bigger the tax reducing adjustments to profit (or non-debt tax shields), the lower the companys motivation to use debt for tax deduction purposes is. Companies with relatively high non-debt tax shields are believed to have relatively less debt in total capital. However, some studies (Scott, 1977; Moore, 1986) support the opposite argument. Higher investments (pertaining to higher non-debt tax shields) are believed to result in a companys improved ability and motivation to acquire secured debt (relating to higher debt tax shields).
The determinants of companies dividend policy and its consequences on capital structure have been explored in a large number of papers starting from Miller and Modigliani (1961), Gordon (1959) and Lintner (1962) to very many recent interpretations. However, the consequences of dividend restrictions have received very little attention. Wald (1999) found that dividend restrictions result in more profitable firms (those with a higher average product of capital) having lower debt to equity ratios. Walds paper is however focused on the consequences of contractual (and not statutory) dividend restrictions. Wald and Long (2005) addressed the effect of the US state laws on companies capital structure, finding, among other conclusions, that the US state laws on payout restrictions appear to reduce leverage for firms that have not reincorporated outside their home states.
Numerous empirical studies have been carried out to substantiate the existence and importance of the factors that influence companies capital structure. These studies include Titman and Wessels (1988), MacKie-Mason (1990) and Welch (2004), among many others. Examples of empirical studies based on (some of) the EU countries data include Cornelli et al. (1998), Nivorozhkin (2005), Haas and Peeters (2006) and Jõeveer (2006). A comprehensive comparison of empirical research can be found in Prasad et al. (2001). Similarly to the theoretical literature, there is no consent on the impact of legislation and other factors on companies financing decisions.
MATERIALS AND METHODS
Hazak (2006a) has dealt from a theoretical perspective with the specific impact of thin capitalisation rules on capital structure. These rules are hypothesised to result in increased demand for debt in order to finance the additional income tax expense for a company, which (1) prefers debt (inclusive of the adverse impacts of thin capitalisation rules on the cost of debt) to equity and (2) has utilized debt finance beyond the statutory thin capitalisation threshold. For a contrary effect, thin capitalisation rules are hypothesised to result in decreased demand for debt for a company, which (1) normally prefers debt to equity, but due to the adverse effects of thin capitalisation rules on the cost of debt is forced to start preferring equity and (2) has utilized debt finance in a larger volume than the statutory thin capitalisation limit. In case equity becomes more favourable than debt as a result of thin capitalisation rules, the companys equity is hypothetically higher than that of a similar company in an economy with no thin capitalisation rules. The negative impact of thin capitalisation rules is expected to be higher for companies and industries, which would normally rely more heavily on debt and less on equity. Companies and industries, which are in relatively higher need for debt, potentially have a comparative advantage for development in the countries where no or less strict thin capitalisation rules have been enforced.
The specific impact of statutory dividend restrictions on capital structure is addressed by Hazak (2006a). In general, there are two main types of statutory dividend restrictions: (1) limitations on the maximum amount of accumulated net profit, which can be distributed as dividends and (2) requirements on the minimum amount of dividends that the company has to distribute out of its annual profit (i.e., mandatory dividends). Based on the theoretical argument presented in that paper, it is hypothesised that limitations on the distribution of a companys accumulated net profit as dividends result in higher equity capital in comparison to the situation where no such restrictions exist and, thus, decreased demand for debt. This statement is hypothesised to be valid if debt finance is less costly for a company than equity capital. Mandatory dividends, however, appear to have no significant impact on companies capital structure.
Hazak (2006a) has also discussed the impact of minimum share capital and minimum equity requirements on companies capital structure. The minimum amount of share capital needed to start and operate a company tends to be established by law. These amounts are fixed at different levels, depending on the type of the company and on the country where the company operates. Requirements concerning the minimum size of equity represent a statutory obligation for a company to maintain its total equity above a certain level, defined as a percentage of share capital, as a fixed amount or otherwise. The theoretical analysis in that study reveals that these two types of statutory regulations have no impact on companies choices between debt and equity financing. However, in case of very small companies in certain jurisdictions with a high minimum share capital requirement, equity capital is potentially higher than the voluntary level. It should be noted that the potential impact of taxation on mandatory dividends as well as minimum share capital and equity requirements is excluded from the analysis in the model presented by Hazak (2006a). Inclusion of the effect of investor and company level taxation, if any, may have lead to different results.
The following summary of statutory regulations in the EU countries is based on the same survey as partially presented by Hazak and Mäe (2006), giving overview of statutory minimum share capital and equity requirements, dividend restrictions and thin capitalisation rules over the period 2000 to 2005.
Table 1 summarizes minimum share capital requirements in these EU countries where such regulations exist over the period 2000 to 2005. Minimum share capital amount needed to operate a limited liability company has been indicated. In case it is possible to operate different types of limited liability companies in one country, the smallest of the respective minimum share capital amounts has been presented in the Table 1. It should be noted that exceptions may apply to the amounts shown in the table, e.g., for companies of specific industries.
There exist significant differences in the statutory minimum share capital amounts. Out of the EU countries the minimum share capital required to operate a limited liability company is highest in Austria, being equal to 35 thousand Euros. On the other hand, France (starting from 2003), the United Kingdom, Ireland and Cyprus have not established any minimum share capital requirements for (certain types of) limited liability companies.
Minimum equity regulations in the EU countries usually establish a requirement to improve the equity position (e.g., by investors injecting additional share capital or by decreasing the share capital to net off the accumulated losses) in case (1) the accumulated net loss of the company exceeds a certain percentage of share capital, or (2) total equity falls below a certain percentage of share capital.
Table 2 summarizes equity requirements in the EU countries over the period 2000 to 2005, showing minimum equity as percentage of share capital (i.e., recalculated to minimum equity requirement if the regulation is a maximum net loss restriction) for all the countries where such regulations exist.
Table 1: | Minimum share capital requirements (EU, 2000-2005; EUR in thousands) |
Hazak and Mäe (2006); legislation of respective countries |
Table 2: | Minimum equity requirement as percentage of share capital (EU, 2000-2005) |
Hazak and Mäe (2006); legislation of respective countries |
There have been no minimum equity requirements established in Cyprus, Germany, Ireland, Latvia, Malta, the Netherlands, Poland, Portugal, Slovakia, Sweden and the United Kingdom. In these countries, where such requirements exist, the minimum equity amount ranges from equal to 8% of share capital in Austria to 67% of share capital in Italy and Spain.
In the EU countries limitations on the distribution of net accumulated profit as dividends tend to be defined as a percentage of annual net profit, which has to be retained as a reserve for potential future losses until such a reserve becomes at least equal to a certain percentage of share capital. Table 3 and 4 summarize these regulations in 2000 to 2005 for these EU countries where such legislation exists.
Some EU countries, like Cyprus, Denmark, Finland, Germany, Hungary, Ireland, Latvia, Malta, the Netherlands, Poland and the United Kingdom do not require this kind of a reserve to be created (for certain types of companies). The opposite extreme is Greece, where the amount of accumulated net profit, which has to be retained as a reserve for potential future losses, is set at 33% of share capital. In these EU countries, which require a minimum undistributable reserve to be created, the minimum percentage of annual profit to be transferred to the reserve is either 10% (Spain and Sweden) or 5% (other countries).
Table 3: | Minimum percentage of share capital in the extent of which retained earnings have to be retained as an undistributable reserve (EU, 2000-2005) |
Hazak and Mäe (2006); legislation of respective countries |
Table 4: | Minimum percentage of annual net profit to be retained as an undistributable reserve (EU, 2000-2005) |
Hazak and Mäe (2006); legislation of respective countries |
In addition to the limitations due to an obligatory reserve, the regulations adopted in the EU countries exclude certain revenues from distributable profits or deduct the net book value of certain assets from distributable profits. These limitations are company and industry specific and difficult to quantify.
Out of the EU countries, Greece has established a minimum dividend requirement. A minimum annual dividend of the higher of 6% of share capital and 35% of profits is payable (unless 80% of shareholders waive their entitlement) in Greece.
Table 5 summarizes thin capitalisation rules in the EU countries over the period 2000 to 2005, expressed as maximum debt to equity ratio defined by law to determine whether a company is thinly capitalized or not. Data is provided only for these countries where thin capitalisation rules exist.
There have been no thin capitalisation rules established in Austria, Belgium, Cyprus, Estonia, Finland, Greece, Ireland, Lithuania, Malta, Slovenia, Sweden and the United Kingdom. In these countries, where thin capitalisation rules have been put into effect, the maximum statutory debt to equity ratio ranged from 1.5 in France and Germany to 5.7 in Luxembourg.
The company level empirical information has been gathered from the Amadeus database by Bureau van Dijk. The version of the database available for this analysis includes data of 276,840 European companies. Financial and other business information for the period 2000 to 2004 was collected in respect of these companies, which (1) operate in the EU countries; (2) have been active during the entire period of 2000 to 2004 (i.e., companies that have had continuous activities); (3) information regarding debt and equity components as well as annual revenues and profits was available for all the five years from 2000 to 2004 (i.e., companies with no missing data); (4) do not belong to the financial sector (NACE industry codes 65 to 67) (i.e., companies with fundamentally different financial structure); (e) do not have any negative debt components for any of the five years from 2000 to 2004 (i.e., evidently inappropriate financial information).
Table 5: | Maximum debt to equity ratio for statutory thin capitalisation purposes (EU, 2000-2005) |
Hazak and Mäe (2006); legislation of respective countries |
Due to the above criteria, the sample used for the empirical analysis covers 35,759 companies. It should be noted that the database did not include information meeting the above criteria for any Slovenian, Danish and Cypriot companies (all of them lack 2000 data). Also, the number of Maltese, Austrian, Luxembourgs and Greek entities (less than 100 per country) may be considered to be relatively small to give a representative overview of the financial behaviour of the companies in these countries.
In order to distinguish companies which prefer debt to equity (as required for preliminary testing of some of the hypothesis by Hazak (2006a, b) from companies that are equity preferring, the 10% leverage ratio (long and short term debt in total capital employed) as in 2004 has been used as the breakpoint. For the purposes of this survey, total capital employed is defined as total equity capital plus long and short term debt. 23,999 companies or 67% of the total sample had used debt in higher extent than 10% of total capital and have therefore been considered as companies preferring debt to equity. It should be noted that in addition to the poorly represented countries mentioned in the previous section, the company sample from Hungary deems to be relatively unrepresentative, whereas only 8.3% of companies qualify as debt preferring, compared to the sample average of 67%. Appendix 1 gives a breakdown of the sample by countries and by years.
Descriptive statistics has been used as an easy initial approach to analyze the relations under consideration. Further analysis with more sophisticated methods and with the incorporation of various micro and macro level control variables would represent an interesting area for future research in respect of these issues where the introductory analysis presented in this paper gives mixed or insufficient evidence.
RESULTS AND DISCUSSION
In respect of minimum share capital requirements the average percentage of the statutory minimum share capital amount in total capital employed was calculated by countries. The results of this preliminary analysis are summarized in Fig. 1.
The analysis reveals that minimum share capital amount constitutes on average only 0.06% of total capital employed by the companies included in the sample. These average percentages vary only slightly, maximum being 0.40% and minimum below 0.00% of total capital employed. The robustness of the results was controlled for by a similar analysis by industries (NACE 2-digit classification). Dispersion of results was relatively minor in this case as well with maximum industry average share of minimum share capital in total capital employed being 0.75% and minimum below 0.00%. Overall, the results support the theory-based hypothesis by Hazak (2006a) that minimum share capital requirements do not represent a significant factor in companies capital structure formation.
Fig. 1: | Minimum required share capital as average percentage of total capital employed by countries (2000-2004) |
Table 6: | Number of companies not meeting minimum equity requirements (2000-2004) |
Present analysis based on Amadeus database data |
As regards minimum equity requirements, first, the number of companies in the sample, which do not meet the minimum equity requirements, has been identified by countries (and the robustness of the results controlled for by a similar analysis by industries). Table 6 summarizes the results of this analysis.
In all the 5 years under review, the EU average number of companies, which did not meet the minimum share capital requirements, was only 4% of total companies. For individual countries that have established minimum equity requirements, the share of non-compliant companies ranges between 2 and 9%, except for Luxembourg (3-12%) and Greece (13-23%). In the latter two countries, however, the relatively small sample (33 and 70 companies, respectively) might distort results in analysing the number of companies not meeting the equity requirements.
Second, in order to identify the impact, if any, of minimum equity requirements on the capital structure of the companies in the sample, the country and industry average leverages of companies operating within the conditions of different minimum equity requirements have been compared to these of companies that operate in countries where no minimum equity requirements exist. The analysis by countries and by industries for the five year period of 2000 to 2005 shows that there are no clear differences in the capital structure of companies operating within the conditions of minimum equity requirements in comparison to companies that do not have to follow any minimum equity rules. Furthermore, there seem to be no significant differences in the capital structure of companies, depending on whether the company is operating in a country with high or low minimum equity requirements. In general, further empirical analysis with more developed econometric methods would be needed in this area.
In respect of dividend restrictions, leverage of debt preferring companies has been compared on country average basis for different minimum reserve requirements. Appendix 2 summarizes these results. It appears that in these countries where no dividend restrictions exist, companies use on average more debt financing than in these countries where such regulations exist. Exceptions to this overall finding are Hungary, Finland and Latvia in certain years, which may be the consequence of other legal or country specific factors impact, limited representativity or outlying companies in the sample. In general, the hypothesis by Hazak (2006a) that the existence of minimum equity requirements result in lower use of debt capital, has found support by the above preliminary analysis, though certain yet unexplainable exceptions to this finding exist that draw to the need for further analysis of this issue.
In respect of minimum dividend requirements, it should be noted, that Greece is the only EU country having established a minimum dividend requirement. The number of companies from Greece included in the sample is 70, being potentially not sufficiently representative. Therefore, analysis on a larger sample would be needed to substantiate the theoretical results.
In respect of thin capitalisation rules, debt preferring companies have been grouped by countries and by the existence and the level of thin capitalisation rules. When comparing the average leverage of companies in such groups (Appendix 3), it appears that companies operating in countries where no thin capitalisation rules have been introduced tend to use on average more debt financing than companies in these countries where thin capitalisation rules exist. It can also be noted that the stricter the rules, the lower the companies utilization of debt financing is on average, though dispersion of results is high and therefore the relation is not so clear in these cases. The discrepancies may partially be explained by the fact that companies still prefer debt financing in the conditions of thin capitalisation rules and prefer to pay the income tax on the interest related to the portion of debt exceeding the thin capitalisation threshold. Overall, it may be concluded that the results of the empirical analysis do not give controversial results in light of the hypothesis by Hazak (2006a) as discussed in the literature overview section, but again, more detailed econometric analysis would help to substantiate the results.
CONCLUSION
Comparative analysis of statutory minimum share capital and equity requirements, dividend restrictions and thin capitalisation rules in the EU countries over the period 2000 to 2005 shows significant cross-country differences in respective legislations. At the same time, over the mentioned period these regulations have remained almost unchanged in the EU member states.
Out of the EU countries the minimum share capital required to operate a limited liability company is highest in Austria, being equal to 35 thousand Euros. On the other hand France (starting from 2003), the United Kingdom, Ireland and Cyprus have not established any minimum share capital requirements for (certain types of) limited liability companies. There have been no minimum equity requirements set in Cyprus, Germany, Ireland, Latvia, Malta, the Netherlands, Poland, Portugal, Slovakia, Sweden and the United Kingdom. In these countries, where such requirements exist, the minimum equity amount ranges from equal to 8% of share capital in Austria to 67% of share capital in Italy and Spain.
Some EU countries, like Cyprus, Denmark, Finland, Germany, Hungary, Ireland, Latvia, Malta, the Netherlands, Poland and the United Kingdom do not have dividend restrictions (for certain types of companies). The opposite extreme is Greece, where the amount of accumulated net profit, which has to be retained as a reserve for potential future losses, is set at 33% of share capital. Out of the EU countries, Greece is the only jurisdiction that has established a minimum dividend requirement. A minimum annual dividend of the higher of 6% of share capital and 35% of profits is payable (unless 80% of shareholders waive their entitlement). In these countries, where thin capitalisation rules have been put into effect, the maximum statutory debt to equity ratio ranged from 1.5 in France and Germany to 5.7 in Luxembourg.
The empirical analysis presented in the study, that is based on a sample of companies and their financial information from the Amadeus database, gives support to the hypothesis that statutory maximum dividend restrictions (i.e., limitations on the amount of accumulated net profit which can be paid out as dividends) result in higher equity capital, compared to the situation where no such restrictions exist and thus lower demand for debt. As regards the opposite type of dividend regulations, minimum dividend requirement, more detailed econometric analysis on a larger sample would be needed to substantiate the capital structure effects.
Based on the empirical analysis presented in this paper, requirements concerning the minimum levels of share capital and equity, as expected, do not have a significant impact on companies choices between equity and debt financing. It appears that companies operating in countries where no thin capitalisation rules have been introduced tend to use on average more debt financing than companies in these countries where thin capitalisation rules exist. Further econometric analysis with the incorporation of various micro and macro level control variables would represent an interesting area for future research.
ACKNOWLEDGMENTS
The author is grateful to his colleagues from Price Waterhouse Coopers EU offices for their help in gathering and interpreting the information in respect of the statutory regulations in their countries and to Mari Mäe. All the mistakes and views expressed in this paper remain the responsibility of the author. This research benefited from the support of the Doctoral School in Economics of the University of Tartu and Tallinn University of Technology.
APPENDIX
Appendix 1: | Overview of the sample |
Source: Authors calculations |
Appendix 2: | Average leverage of companies by minimum reserve requirements and by countries (2000-2004) |
Source: Authors analysis based on Amadeus database data |
Appendix 3: | Average leverage of companies by thin capitalisation rules and by countries (2000-2004) |
Source: Authors analysis based on Amadeus database data |
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